New Private Fund Adviser Rules: Prepare for Fee and Expense Reporting

Louis Bruno:

Thanks, TaNeka. It's interesting. Over the last several years, the SEC has issued enforcement actions against private fund managers specifically for their fee and expense allocation practices. Hedge funds and private equity, fund managers alike, have been cited specifically for failure to disclose fee and expense allocation methodologies in their offering documents, but then also failure to provide evidence or support allocation of fee and expenses were allocated equitably amongst the funds and specifically in separate managed accounts. So the regulation behind this is all of course, the investment advisors act of 1940, and it talks specifically about some of the requirements, the charging fees and expenses. There's also a piece in there about the fiduciary duty that aligns to a lot of the topics here. The violations certainly, as I mentioned, been significant over the years, and most of the violations relate to, again, a breach of fiduciary duty or the anti-fraud provisions within the regulations. And again, the SEC is absolutely focused on this. It was listed in their exam priorities for 2023. We've seen some cases already this year.

TaNeka Ray:

Well, thank you for that overview, Louis. Now let's delve a little bit deeper into fee and expense allocation. What are some common issues that you and Jeff see when working with our clients when you're reviewing allocations of fee and expenses?

Louis Bruno:

Sure. First of all, one of the things that we see quite a bit is undocumented allocation methodology. Many times private fund managers have procedures to allocate, but they don't necessarily have a documented methodology. And not only do they not have the methodology, but it's unclear sometimes if it aligns to the investor agreements. And so again, those are things that the SEC has certainly noted over the years and things that we've identified as well. Compliance testing is actually another area. Again, sometimes managers are not aware that they're inaccurately allocating fee and expenses and in going through and conducting periodic testing would certainly help with that.

Jeffrey Stomski:

So I'll take a little bit onto what Louis already went through.

If I start at the highest level, I think just looking at consistency between what's disclosed in governing docs, so whether that's a limited partnership agreement, offering memorandums and making sure that squares up against what's disclosed in financials and having an actual policy that's consistent with all items. So when I say policy, usually there's a formal written policy that describes how standard allocations are done. As Louis said, if there's a non-standard allocation or a specific allocation, framework for determining what that allocation is and what that expense is and how it's allocated.

And then I think the biggest thing that we see out there is you could have the policy, you could have everything disclosed in your financials and in your agreements, but the practice of actually evidencing that you're doing this and so many other things commit to it. Louis mentioned the review and the actual testing, but in real time and in documenting the actual decisions and reasons and methodology of why you're allocating an expenses specific way, why you're calculating a fee a specific way, and actually putting pen to paper because down the road, if someone comes in, if auditors come in, SEC comes in, it's just a best practice to be able to point to actual documentation that was done at the time or the allocation at the time of the expense and be able to lay it all out.

TaNeka Ray:

Well, that leads me to the next question. What are some best practices that we see now and how should investment advisors prepare for the requirements that are outlined in the new private fund rule?

Louis Bruno:

I'll say it again. Policy, policy, policy, right? I think we've mentioned a couple of times, but make sure that you document your allocation methodologies and certainly make sure that they align to your disclosures in the investor docs. Mention compliance testing, take a periodic sample and then verify that they're aligned, especially when you have different types of vehicles like separately managed accounts, important to do that testing. And then clearly look at some of the types of expenses, they're expenses that may be considered significantly more costly than an alternative. We always talk about the example of private chartered flights and growing that to regular commercial flights, determine if the allocation truly supports the firm's fiduciary duty.

I would say then, in terms of preparation for the private fund manager rules, again, there's going to be a lot to unpack over the next months and years, so to understand all this, but it's truly, and Jeff highlighted this as well, but it's expense classification. Make sure you're able to understand each type of expense, line it to an activity. And again, that's easier said than done sometimes, especially with unique situations like a private real estate, private fund manager where they have different types of expenses, management and inspections and things like that. And then legal expenses are another good example there. Invoices cross many different types of activities. Make sure you're able to break all of that out.

Jeffrey Stomski:

With respect to just the private fund rule, there's a lot of, we call it litigation, I guess, and ongoing just I don't think we know exactly what the final rule is going to be, but we know some of the components of it and compliance folks tell me if I'm off base on that. But I think that the key thing that you can do or any CFO can do, just sitting in the seat to prepare, is start talking to your service providers, start talking to your attorneys and seeing if anything in your docs needs to be repapered or tweaked to comply with the rule.

If you're using a fund administrator, can they separately, do they have the ability to separately classify any of these expense items in the general ledger and start thinking about how they'd update that and how you'd implement that. Same on the management company side. I'll throw in a little plug, but we're always happy to support any management company bookkeeping services. In there, we're already thinking about how do we classify, how do we expand our general ledger to accommodate all of these expense items, number one. And number two, how do we sit in that review and approval process to, as Louis said, make sure that any expense is permissible by that's being allocated to a fund that is to be permissible through the fund docs, and does that fit in with your policy or allocation methodology. And to fully close the loop, do you have the right documentation in place that brings it all together?

I know we've really beaten that one up a bit. That one's a bit important, and I think that just evidencing the review function is important. There's so many different types of fees and expenses. You have the contractual fees that are more of a management fee or carried interest base. How is management actually performing that review and approving and overseeing the fund administrator's work if you're using that again, that goes down into so many other issues and things that have come out of the SEC recently on just monitoring a service provider, a third party service provider. And looking there and saying, "All right, well, I've delegated the role. I still have the responsibility to review those calculations and to make sure they're done correctly."

I don't mean to beat up the allocation of expenses again, but same thing. You can delegate the bookkeeping service, the role of allocating, but what's ultimately fair to investors in each of the funds? Legal fees was an example. If you're doing something that benefits all the funds, then a proportional allocation based on maybe NAV makes sense. If you have fund docs or updates for a specific entity, specific funds, then that overall pro rata allocation doesn't make so much sense. So I think the fairness and fiduciary responsibility, evaluating that at the top level, and then how that gets down to the funds and the investors being able to have real documentation that's done to support it are the keys.

TaNeka Ray:

Well, that concludes today's discussion of fee and expense allocation. Louis and Jeff, thank you for joining me and sharing your insight. Again, my name is TaNeka Ray with EisnerAmper. I welcome you to connect with us on LinkedIn. Thank you for watching.

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